Tuesday, August 30, 2011

This chart compares Bloomberg's Constant Maturity Commodity Index (white line) to the S&P 500 Index (orange line). From last November through April, these two indices were almost perfectly correlated, suggesting that both were reacting to the same economic growth fundamentals. The correlation broke down over the past month or two, however, as equities were overcome by fears that a collapse of the Eurozone banking system could have serious repercussions for the global economy. Commodities initially shared in the onset of panic, but have since bounced back, and today are trading a little above their average for the year to date.

The action in the commodity markets suggests that the economic growth fundamentals have deteriorated much less than the behavior of the equity markets would suggest, and that the fundamentals have actually improved in recent weeks. This is an important development, of course, since growth can trump lots of problems. The Eurozone is far from conquering its sovereign debt problems, but commodity markets suggest that there is at least some concrete hope for a solution.

What I think this shows is a coordinated rumor campaign by short sellers on two continents targeting European banks, and by extension US banks, hyping another 'Lehman event' that allegedly will snowball into a global banking crisis. Similar to last August, the campaign is carried out when most institutional money managers, central bankers, and high ranking politicians are on vacation. The game is to establish large short positions using leveraged derivative products (2 & 3X ETFs, futures, options on same, etc.) and commence a coordinated campaign of nightmare scenarios using sources named as 'pros, analysts, economists, experts, etc', with little or no further qualifications or verifiable data. The media are useful tools since fearful headlines attract far more attention than optimistic ones. Stocks sink on rumors of 'banking collapses' and a cascade of fear begins that quickly spreads to all market sectors. Since memories of 2008 are still fresh, denials from spokesmen from major banks are hooted down and the rout continues...until prices get so cheap that insiders are buying with both hands across all sectors and companies are buying in millions of shares sold by panicing mutual fund investors, and even sopisticated money managers who suspect what is happening but nevertheless fall victim to the fear. With markets already thin, its truly 'fast money' and mighty easy too. Most of the shorts have probably covered their positions and have a little 'house money' riding on a further fall if they can pull it off.

Mighty good work if you can get it. Too bad for the small time schmucks from Alabama, Oklahoma, and Ohio.

You are right. While there has always been volatility in equity markets what has changed in the last several years is the arrival of Wall Street designed products created for the sole purpose of increasing volatility. Highly levered ETFs, long and short versions, narrowed into subsectors as well as broad based ones have brought increased correlation between sectors and companies. Stock selection specialties are losing out to sector and macro analysis. Add the loss of the uptick rule for shorting and 'high frequency trading' machines and short sellers spreading fear have the perfect tools to drop markets in amazingly short periods of time.

The average individual investor has little hope of long term success in such an environment. IMO his only hope is experienced professional guidance and even they can be impacted by the fear...and very few are unaffected by panic. Our equity markets have become casinos for 'fast money' gunslingers with high tech weapons.

Many individual investors are leaving the field and will not be back anytime soon....and I don't blame them. Not one bit.

I think the average investor is misled if he thinks that high frequency trading has increased market volatility to his detriment. In order to increase volatility, HFT would have to "buy high and sell low." This has not been a very profitable strategy, to put it mildly. Any HFT outfit that has been doing this has lost a ton of money, especially this past month.

It's more likely that HFT strategies have focused on the traditional role of speculators, which is to "buy low and sell high." This adds liquidity to the market and dampens volatility.

High frequency trading has a huge effect on illiquid and low volume stocks which they love to attack. They add ZERO real liquidity and are most effective in high volatility situations. They are definately designed to 'move' markets.

These machines can also sell short, (selling first and closing the trade with a buy). I do not see these machines acting in a similar capacity as a specialist who moderates downturns by buying and tempers upswings with selling. I think they are programmed to identify trends and capitalize on them.

In fairness, they are direction agnostic. But I do believe they increase market volatility.

There have been studies that portend their innocence but the average small investor does not believe it. And at the end of the day, I think that is what matters. The market's credibility as an honest place to do business is seriously in question with a lot of people. That's not a good thing. And I don't think the machines are worth losing that.

Thank you for addressing my post. You are providing a fantastic service to a lot of people. I, for one, really appreciate it.

John: Think about what is necessary for a trading strategy to increase the volatility of prices. It can only be a strategy that buys as or after prices rise, and sells after or as prices fall, thus accentuating the ups and downs of natural market oscillations.

Such a strategy is akin to an option-replication strategy, especially one that seeks to replicate a long put option. I know because I spent years working at a firm that designed and implemented these policies.

Portfolio insurance, as it used to be called, works by selling when prices fall and buying when prices rise. Done to excess, it can certainly increase market volatility. It is a strategy, in fact, that exposes one to higher than expected volatility, so it can be self-defeating. Buying high and selling low incurs a cost, and doing it repeatedly can be fatal.

Any strategy that works differently (i.e., does not increase price volatility) can only work by buying low and selling high, and that has the effect of adding liquidity to the market and damping market price oscillations.

Perhaps it is possible for some bold trading strategies to short a stock massively and thereby precipitate a declining trend. But to be profitable that same strategy must at some point buy back all it has sold, thus providing liquidity.

I prefer to think that the difficulty many people have in explaining what moves the market is due not to high frequency trading strategies or sinister plots to depress prices, but rather to the unforeseen and unintended and poorly understood consequences of bad fiscal and monetary policy.

A mysterious market is not a sinister market, but it can demoralize individual investors and it can distract many investors from the real underlying fundamentals which in the end will push prices higher or lower.

The algo/hi freq trading 'systems' are insideous glorified front running 'programs' which only demoralize market depth and participation. They add NO liquidity and search out vulnerable 'thin' issues to attack. Orders are 'layered. with phony orders spoofing the real depth of an issue with the intent of improving the price for a trade the other way. Markets have never been more manipulated since the advent and 'approval' of these very opportunistic systems. If they were all totally shut down the effect would be negligible.